DRIP PORTFOLIO
The Earnings Multiple Mystery
Traits of an ideal stock, Part 1

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By Brian Graney (TMF Panic)
April 12, 2000

Here at the Drip Port, our primary objective and challenge as equity investors is to look forward into the future and project what might happen at the companies we are interested in. However, every now and then, a little peek back into the past can be rewarding as well.

Be forewarned, however. Studying the past can be a trap. Just because some specific chain of events occurred in the past doesn't exactly mean it will happen again in the future. But let's face it -- as an intellectual pursuit, figuring out what happened in the past is a whole heck of a lot easier than figuring out what is going to happen in the future.

When we are not throwing horseshoes in the Fool's lobby or temper tantrums in the Fool's conference rooms, Jeff and I while away our hours at work trying to determine which stocks will make ideal long-term investments. So, what's our definition of an "ideal stock?" Former Drip Port manager Randy Befumo once defined an ideal stock this way:

A company that can generate above average earnings growth that is currently selling at a below average price/earnings ratio.

Let's look at this definition a little closer. For illustrative purposes, we will dip into the past and use one of the best performing stocks of the last decade as an example.

Maxim Integrated Products
(Nasdaq: MXIM) is one of the rarest of all stock market creatures -- a 100-bagger that scarcely anybody has ever heard of. During the 1990s, the Sunnyvale, California-based firm posted a stunning 57% compound annual return by designing and manufacturing a broad range of linear and mixed-signal integrated circuits, commonly referred to as analog circuits. In this case, the word "broad" is key -- the company had introduced more than a whopping 1,780 different products as of last July. Despite tons of competition, Maxim has done quite well for itself over the years, as its parabolic share price chart can attest. (For those who may be wondering, the company unfortunately does not offer a DRIP. Sorry.)

Instead of focusing on the past 10 years in toto, we'll look at how the business has performed over a more reasonable period of time -- say, the past three years. With any luck, maybe we can find some hints explaining the company's special value creation ability. From the end of 1996 through the end of 1999, Maxim's market capitalization ballooned from $1.5 billion to $7.2 billion, a blistering 67% compound annual rate. So much for Y2K and the idea of coasting through the end of the decade!

So, how did Maxim manage to rack up such an impressive performance record? In pure Richard Dawson, Family Feud style, we surveyed 100 financial analysts and tallied their most popular responses.

... Surveyyy Said!!

Answer No. 1: Was it through margin expansion? Nope.

                        1996   1997   1998   1999
Operating margin       44.1%  45.9%  45.5%  45.6%

Answer No. 2: Was it through return on average equity expansion? No, strike two.

                        1996   1997   1998   1999
Return on Av. Equity     49%    35%    32%    26%

Answer No. 3: Was it through earnings per share expansion? Not entirely, but we're finally starting to get somewhere. (Earnings compounded at a 17% annual rate.)

                        1996   1997   1998   1999
Annual Diluted EPS     $0.87  $0.94  $1.18  $1.29

Answer No. 4: Was it through price-earnings multiple expansion? Aha! Now there's the ticket.

                        1996   1997   1998   1999
Year-End Trailing P/E  12.4x  18.3x  18.5x  36.6x

If multiple expansion has been so crucial to explaining Maxim's outstanding performance in the recent past, how do we as investors go about trying to project future multiple expansion when evaluating stocks in the here-and-now? Said a different way, is there a way for investors to possibly predict multiple expansion? We'll tackle that question in Friday's column.

Drip Portfolio

4/12/2000 Closing Numbers
Ticker Company Day Chg % Chg Price
CPBCAMPBELL SOUP15/163.28%$29.50
INTCINTEL CORP-8 7/8-6.79%$121.88
JNJJOHNSON & JOHNSON-1 1/4-1.60%$77.00
MELMELLON FINANCIAL CORP15/166.19%$33.25

  Day Week Month Year
To Date
Since
7/28/1997
Annualized
Drip -2.89% -3.56% -.79% 14.36% 48.58% 15.73%
S&P 500 -2.23% -3.24% -2.10% -.14% 56.28% 17.91%
S&P 500(DA) -2.23% -3.24% -2.10% -.14% 58.91% 18.63%
S&P 500(DCA) n/a n/a n/a n/a 29.25% 9.93%
NASDAQ -7.06% -15.22% -17.56% -7.36% 140.17% 38.16%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
9/8/199722.9859INTC45.653$121.88166.96%
11/14/199713.323JNJ79.310$77.00-2.91%
11/5/199831.5773MEL34.290$33.25-3.03%
4/13/19988.269CPB54.401$29.50-45.77%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
9/8/199722.9859INTC$1,049.37$2,801.41$1,752.04
11/14/199713.323JNJ$1,056.65$1,025.87($30.77)
11/5/199831.5773MEL$1,082.79$1,049.95($32.85)
4/13/19988.269CPB$449.84$243.94($205.90)
  Cash: $24.47  
  Total: $5,145.63  


Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.

Note
Drip Port launched with $500 on July 28, 1997, adds $100 to invest every month, and the goal is to own $150,000 in stock by August of the year 2017. Due to the slow nature of dollar-cost-averaging and our relatively significant starting costs, we do not expect to seriously challenge the S&P 500 for the first three to five years as we build an investment base. The long-term advantages of dollar-cost-averaging still overcome the short-term disadvantages, however. Final note: our investment in Campbell Soup is frozen due to fees instituted in its investment plan. Click here for a history of all Drip Port transactions.